As of September 30th, the bond market is celebrating a 40-year run, the greatest bull market on record.  On Sept. 30, 1981, amid high inflation and crippling recession, the Treasury 10-year note yielded a record high 15.82%.  Yields, which had been rising since the end of World War II, suddenly reversed. Shock therapy delivered by Paul Volcker’s Federal Reserve finally slowed inflation. Yields would continue to fall for the next four decades.  With the 10-year yield recently checking back to the 1.25% range, it’s hard to see much value investing in bonds today, particularly with inflation readings of over 4% over the last few months.  The idea of ‘locking in’ a negative real rate of return for the next ten years hardly sounds alluring!  Clearly that’s the primary reason why investment money keeps flowing into stocks and real assets.

Is the recovery trade still alive?  After the ‘value-oriented’ recovery stocks lead the market higher from the November 2020 announcement of Covid vaccines until June of this year, we have seen the growth stocks come back into vogue over the summer months as the economic worries about the impact of the Delta variant and a rallying bond market supported the tech and ‘stay at home’ stocks that had lead the market from March to November 2020.  While sticking with this ‘value trade’ over the summer has tested the patience of investors, we believe that the stock market will migrate from a ‘liquidity driven market’ to an ‘earnings driven market.’  The risk in bond yields in late September might be an indication that better growth lies ahead.  Although the recovery is being delayed by a 4th wave of covid,  a low level of global vaccines and the overall supply shortage in many goods markets, we still see the economy as being early in a new recovery cycle.  We favour the cyclical groups such as energy, industrials, financials and autos, where we see strong earnings recoveries and much lower valuations than in the ‘growth sector’ of the market such as technology.   While we see continued growth in the big tech names, we are wary of the valuations and believe those stocks could lag the overall stock market.  The chart below shows that, while all stocks are trading at elevated valuations, the Growth Index is at a premium to the Value Index not seen since the end of the ‘tech bubble’ in 2000, at which point the Value Index outperformed for the following decade, albeit one in which global economic growth continued unabated.

Are energy stocks over the next decade the tobacco stocks of the 1980s?  With valuations at cycle lows and energy prices surging in the past eighteen months, energy stocks had still lagged the market due to worries about slowing demand for hydrocarbons and ESG concerns that have caused many major investors to leave the sector.  Much like when advertising in the tobacco industry was cut off and the anti-smoking health issues arose, investors started to abandon the tobacco stocks decades ago.  However, the fact that there was no expansion meant no capital spending along with no advertising, so these companies began to generate huge free cash flows, which they invested in other growth industries and the stocks ended up doing quite well.  The same situation is occurring in the energy sector now, with growth being eschewed in favour of debt paydowns, dividend increases and stock buybacks.   We have also seen many of these companies use their excess cash flows to invest in renewable energy projects, which will end up helping sustain some growth.  This has helped the energy sector recover to lead the market this year after lagging throughout 2020.

However, while the long overdue rally in energy stocks is clearly helping investment results this year, we should not lose sight of the fact that this industry is in secular decline.  Global oil demand is expected to peak before 2030, earlier than previously projected, Total Energy.  The French oil major forecast is working on the assumption that global consumption would start declining before the end of the decade.  Oil demand would drop to as low as million barrels per day by 2050.  To put that in perspective, the world consumed 99.7 million barrels per day of oil in 2019, before the COVID-19 pandemic hammered economic.  The Paris-based group also said it expected power generation to more than double by 2050, with wind and solar energy accounting for more than 85% of the increase.  More importantly for investors though, is the fact that major pension funds all over the world have been reducing their investments in fossil fuels.  This constant selling pressure has depressed sector valuations despite the improvement in the industry fundamentals over the past year.  These announcements have now come closer to home as the Caisse de dépôt et placement du Québec is divesting its remaining oil-producing assets and setting up a $10-billion fund to decarbonize other high-emitting industrial sectors in a new stage of its strategy to get to net zero emissions by 2050.  The pension fund said that it will jettison oil holdings, which make up 1% of its portfolio, by the end of next year. The Caisse currently owns about $4-billion in shares of Canadian and international oil producers.  It will remain invested in oil pipelines as part of its infrastructure.  New targets include holding $54-billion in green assets by 2025 and achieving a 60% cut in carbon intensity by 2030. It now has $36-billion in green assets, including renewable energy and sustainable real estate.  The announcement is the latest by a major Canadian pension plan dealing with climate-related risks. Earlier this month, Ontario Teachers’ Pension Plan said it aims to vastly increase clean-energy investments and push companies in its portfolio to set paths to net-zero.  Bottom line, there are going to be a lot more sellers than buyers of non-renewable energy stocks over the next decade, and that is going to keep valuations depressed.  On the bright side, non-renewable stocks have sold off this year and their valuations have become more reasonable, making them more attractive entry points for longer term investors.  Canadian stocks Northland Power, Algonquin Power and Boralex currently top our list of best ideas in that sector.

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